BUILDING SOCIETIES ASSOCIATION SEMINAR
ADDRESSING THE PRACTICAL REALITIES
A POSITIVE VIEW FROM A SCEPTICAL EURO-ENTHUSIAST
This paper is based on a talk given by John Chown at a one-day seminar organised by the Building Societies Association2 on 31 March 1998 under the general title "EMU - addressing the practical realities".
Although our main professional concern is with the tax aspects 3, these were only briefly mentioned at the seminar and are not covered in this paper.
Introduction
My role at this seminar is to offer an economist's overview of some of the issues raised by monetary union: I intend to be provocative, perhaps even subversive, but above all to make some practical suggestions. Where do I come from? I welcome the great achievements of the European Union in making it easier for Europeans to live together in peace and harmony and to travel and trade freely across frontiers, and have no objection in principle to surrendering defined aspects of national sovereignty to a (democratically accountable) supra-national body. To that extent I am a Euro-enthusiast. As a citizen I want to be competently but lightly governed and do not welcome unnecessary meddling, be it Brussels, Westminster, or my local council which unfortunately is Camden, but the main reason why I am now a sceptical Euro-enthusiast is because of doubt about the way in which the serious technical problems are being handled by those pushing the venture forward.
My colleagues and I have written an article for
Economic Affairs4 which argues neither for nor against EMU, but examines the problems and discusses how business, and governments (including Eastern European governments) should react to them. Its sub-title "With friends like these, who needs enemies?" sums up our position and indeed we argue that the very future of the European idea may well depend on the efforts of the sceptics to ensure that the project is founded on sound economic analysis rather than mere political exuberance.
General Principles
One of my hobbies is studying
monetary history5 and any such study puts one's prejudices and generalisations into perspective. I am still left with two which I will share with you:
1. History shows that any long period of living with rigidly fixed exchange rates swings opinion in favour of the benefits of flexibility, while after a period of floating rates, the public starts to yearn for the certainty of fixed rates!
2. Whenever politicians and rulers, whether Nero, Henry VIII, Harold Wilson or Chancellor Kohl, take it upon themselves to interfere in monetary arrangements for political ends, there will be tears before bedtime.
The move towards monetary union has a huge political momentum but the politicians and particularly the Eurocrats, seem to be treating it as a 'selling' exercise and dismiss the questions of the economists, not as technical problems to be overcome, but the equivalent of the tedious objections put up by Euro-sceptics: friendly critics are dismissed, as Margaret Thatcher used to say, as "not one of us". It is in fact precisely these questions which raise problems (and create opportunities) for business, and my task today is to guide you through them.
Likely Scenarios
We are told that we must plan for a
single currency future.6 You all accept this or you would not be here today. Plans, though, must take account of several different scenarios. Monetary union will almost certainly go ahead on the present timetable with 11 members, with the United Kingdom having a fairly positive watching brief on whether or not to join, but what happens then is harder to call. Certainly the European Union does not meet the economist's criteria for an 'optimum currency area'7 monetary union could create even higher unemployment in some member countries. There are also problems in setting the starting exchange rates at which currencies are to be frozen, determining how monetary policy is to be controlled, and working out how a fixed exchange rate system cope adequately with the adjustments to `asymmetric shocks'. Europe is not like the United States: our labour markets are more inflexible, movement is inhibited by language and other barriers, and (so far) we lack the machinery for the massive fiscal transfers between States which the US uses to deal with regional imbalances.
The optimists hope that an irrevocable monetary union will force countries to adjust to a new reality, and that in the end all will be well in a happily harmonised Europe. The pessimists worry that the whole venture could collapse on its own internal contradictions and that a botched attempt at union could create the very instability the exercise was designed to avoid.
The present consensus amongst informed economic opinion is that Europe is not yet ready for monetary union on the Maastricht timetable and plan, but that there is probably sufficient political momentum to ensure that it will go ahead on the timetable.8 As I shall explain, the political consensus is based on the quite different and possibly mutually incompatible aims of the key governments supporting it. It is unlikely, but not impossible, that these differences will surface soon enough to cause the project to be aborted. There remains a significant danger, that monetary union will go ahead and will then collapse in turmoil, which would set back efforts towards European Union for a generation.9 In practice, we may well muddle through but businesses, and indeed governments, surely need contingency plans to take care of the whole range of possible outcomes.
The UK does not plan to join on the first wave. If we stay out do we risk being side-lined by a successful experiment, joining too late to have any influence on the course of events? If things go wrong, we could benefit substantially from being outside, but there is an even worse scenario. The UK economy is still booming, and UK interest rates are, and still need to be, higher than in Germany: the cycle is out of phase with the Continent. Following the introduction of EMU, the UK economy may well go through a down swing just as their's is booming. What if UK politicians misinterpret this, confuse cause and effect and rush to join just as the whole project is about to end in disaster?
Relative interest rates can be distorted by political events. One of the worst recent examples of political interference with money creating an 'asymmetric shock' to the system was when the East German currency was reunited with the West at a rate chosen by the politicians against all economically competent advice. The horrified Bundesbank had to avoid the risk of inflation by imposing a tight money policy which had, because of EMU, to be followed by other members for whom it was totally inappropriate, and this indirectly lead to the partial collapse of the Exchange Rate Mechanism in 1992.
Our 'Second Currency' Approach
This brings me to my hobbyhorse, an old proposal which is, as I shall show, now again relevant but in a different guise. In 1989, we proposed that "
the Right Road to Monetary Union" 10 should be sign-posted by economic analysis rather than political posturing, and that it should have as its destination the removal of practical obstacles faced by those who wish to trade, invest, or simply travel across the internal frontiers of the European Union.
The most often cited benefit is that foreign exchange losses and costs will be reduced or eliminated. In 1989 we analysed the figures and showed that what business regards as "foreign exchange losses" arise mainly not from currency fluctuations (which tend to average out over time) but from bank charges and commissions based on expensive money transmission arrangements. A later study by
Christopher Johnson11 gave the cost to business of £2.5 billion or 0.33% of GDP, for the UK, and $25 billion for the EU as a whole, of which about a quarter arise from fluctuations, and three-quarters from transaction costs. These figures were remarkably similar to our own 1989 estimates.
This diagnosis suggested to us that there was a simpler and less controversial way of achieving most of these savings, which would have been available years ago and which would actually help rather than hinder an eventual move towards a more formal union. We proposed12 that the EU should immediately encourage the use of the then `basket ecu' as a secondary currency. Businesses and regular travellers would keep a second bank account in ecu, would write cheques in ecu or carry ecu travellers' cheques. For most practical purposes traders, travellers and shopkeepers would deal in only two, rather than fifteen EU currencies - domestic currency and ecu (for which now read Euro). This would simplify and cheapen retail foreign exchange dealings, while any difference between the ecu amounts sent and received across borders would then be clearly identified as transaction costs (bank charges), rather than as `exchange rate losses'.
If this proposal had been adopted (and had been coupled with a serious assault by the Commission on uncompetitive banking practices) at least half of the "transaction cost" (but of course none of the "exchange risk") savings could have been achieved by 1994 - at least five years ahead of, and without prejudice to, the targets for full monetary union. Our `half baked' approach would have more than paid off the transitional costs of Monetary Union before it even began!
Since 1989 technology has come a long way, and foreign exchange business can now be handled electronically and at little cost. It is certainly highly desirable that we reduce and, if possible eliminate, the transaction costs involved in cross-border payments. This could give a great advantage to organisations which, not having huge sunk cost in out of date technology and procedures could undercut the competition for the general public good.
It is inevitable that a great deal of UK wholesale business will be conducted in Euro, but business in general and building societies in particular should calculate on the Euro becoming a widely used second currency within the UK. There will certainly be a demand for Euro mortgages and if the UK building societies do not provide these, German competitors undoubtedly will. Get it right and you can sell mortgages to the Germans!
One obvious way of financing such mortgages is to offer to accept deposits in Euros. I am not an IT specialist but it is surely easy enough to convert a computer system from one currency to another: the problem is in maintaining two currencies simultaneously. If I may make an outrageous suggestion, two building societies could merge or agree to co-operate, one dedicating its existing systems to pounds and the other to Euros.
There may well be a mismatch between assets and liabilities but this can easily be hedged using derivatives markets. Yes, I know that many companies have lost vast sums speculating in derivatives but this is because they have relied on salesmen who have talked them into the wrong transaction instead of acquiring in-house expertise themselves. Derivatives, properly used, are a very powerful tool indeed and can solve, efficiently and cheaply, many of the problems of living in a multi-currency world.
The Politics
What of the politics? EMU is likely to happen politically even if the economic arguments are unconvincing. Nations "like France, Italy and Spain, gradually realised that they had lost control of their domestic monetary policy".
13 (They needed a new institution in which they would have a voice.) There is also a contrast between political will and economic reality: a "strange mixture of pro-European internationalism and the pursuit of narrowly defined national self-interest"14 mutually contradictory aims which together "may propel Europe into a monetary union." France and others see EMU as an opportunity to escape from German domination. Germany's motives are "harder to understand": they either see it as a means to reduce the risk of conflict (but monetary union did not prevent the American Civil War) or as an opportunity to reinforce their role as natural leaders of the EU, aided by new allies from its Eastward expansion.
Conclusion
The monetary union project clearly has a tremendous political momentum, but it is not backed by economic analysis, so the supporters of the project treat those who raise economic issues as mere obstructionists. Nevertheless, sooner or later the economic reality must dominate. The best that can then be hoped for is that problems as they arise are dealt with successfully, albeit perhaps painfully.
Perhaps I can add a third to my two 'lessons of history'. Monetary unions can collapse and although the break-up of the Latin Monetary Union, the Scandinavian Monetary Union, the Soviet Union, the Austro-Hungarian Empire and former Yugoslavia are not close parallels, they have something to teach us.
15 A hundred years ago, most of the British Empire (notable exceptions being Canada and India) used British currency. Australia, in 1897, was the first to introduce its own monetary legislation while retaining the link with sterling. Some countries broke away after independence, and others after the 1969 devaluation - each step a break away from a monetary union. The consequences, including the legal consequences, make an interesting study.
1
J F Chown & Company Limited, 51 Lafone Street, London SE1 2LX.Author of "A History of Money" (Routledge 1994, paperback 1996) and (with Kim Desai) "The Taxation of Foreign Exchange and Derivatives" (Financial Times Management Report, 1997).2
Building Societies Association seminar, 31 March 1998: Addressing the Practical Realities: Interest Rates and the Money Markets Situation.3
Chown, John "The Changeover and Taxation", contributory chapter in "User Guide to the Euro", eds. Graham Bishop, José Pérez and Sammy van Tuyll, published by the Federal Trust, Distributed by Sweet & Maxwell, ISBN 0 90157362 0. London, 1996. See also two articles in "The Single Currency in Practice" (Financial Times group) "The taxation of derivatives and foreign exchange the impact of monetary union"; and "The effect of EMU on Company Taxation" (January 1998) and "ECU, The Currency of Europe", edited by Christopher Johnson, Euromoney, 1991, Chapter 14 "The Accounting and tax treatment of Ecu transactions", John Chown4
How to rescue European Monetary Union: with friends like these, who needs enemies? John Chown, Massimo Beber, and Geoffrey Wood. To be published in Economic Affairs June 1998. Institute of Economic Affairs, 2 Lord North Street, London SW1P 3LB5
Chown, John: "A History of Money", Routledge 1994, paperback 1996.6
Practical Issues arising from the Introduction of the Euro. Issue No ? Bank of England 12 March 1998.7
Pedro Schwarz, "Back from the Brink: An Appeal to Fellow Europeans Over Monetary Union", Institute of Economic Affairs, London 1997 (Occasional Paper 101). Robert Mundell "A Theory of Optimum Currency Areas", American Economic Review, 1961; and Milton Friedman, Times 19 November 1997.8
"Thinking the Unthinkable about EMU", NIESR Conference 24 November 1997.9
David Lascelles,, "The Crash of 2003. An EMU fairy tale", Centre for the Study of Financial Innovation, 18 Curzon Street, London W1Y 7AD, December 1996.10
John Chown and Geoffrey Wood "The Right Road to Monetary Union", Institute of Economic Affairs, London 2 October 1989 (IEA Inquiry No 11). Also published in Economic Affairs, February/March 1990 and reprinted in Russel Lewis (ed.) Recent Controversies in Political Economy, Routledge, London 1992. They were revised in 1991 and 1994 - see below.11
Christopher Johnson, "In with the Euro Out with the Pound", Penguin, 1996: p. 43, p. 151 and Table 18.12
John Chown and Geoffrey Wood "The Right Road to Monetary Union", Institute of Economic Affairs, London 2 October 1989 (IEA Inquiry No 11). Also published in Economic Affairs ,February/March 1990 and reprinted in Russel Lewis (ed.) Recent Controversies in Political Economy, Routledge, London 1992.13
Wyplosz, Charles EMU: Why and How It Might Happen. Journal of Economic Perspectives Vol. 11 no 4, Fall 1997 pages 3-2214
Feldstein, Martin The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability. Journal of Economic Perspectives Vol. 11 no 4, Fall 1997 pages 23-4215
John Chown's work in progress towards sequel to "A History of Money" has the provisional working title "Monetary Unions and 'Disunions'".